Due diligence is most critical to buyers in M&A transactions. If done properly it will provide a prospective buyer with insight on Seller’s business, its earnings, and liabilities. Due diligence determines price, deal structure, and post-acquisition planning.
While every situation is different, the following are some areas that a buyer must look into:
- Revenue
Revenue of the Seller must be analyzed. It should be recognized in the proper period as well as the cost related to generating such revenue. Generally accepted accounting principles (GAAP) should be applied consistently over years. - Adjustment
Adjustment should be looked at in great detail. Items include abnormal compensation, perks, certain non-recurring incomes and expenses. Accounting adjustment also impacts earnings. These adjustments, such as doubtful accounts, inventory reserves, warranty reserves, and accrued liabilities should all be analyzed for potential inflation of earnings. - Inventory valuation
Capitalization of costs into inventory should be closely assessed to determine the appropriateness of such valuation. Such capitalization will have a direct impact on earnings. - Pro forma cost adjustments and others
Pro forma cost might include restructuring or financing costs, so the Buyer should watch closely and determine whether they are appropriate.
There are other areas to investigate, for example, the Buyer should investigate the fitness of Seller’s business, its management team, and its information systems. Liability of the Seller is also critical. This includes debt, both recorded and non-recorded on the balance sheet, lawsuits, and other claims. Finally, capital expenditures in the past years and a forecast should also be obtained.
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